Nike Inc.

: Cost of Capital Submitted by: Usman Riaz

This case study is about a portfolio manager, Kimi Ford, who worked for North Point Group. North Point Group invested in the S&P 500 stocks and was focused on value investment. Kimi Ford was trying to valuate Nikes stock so that she could invest in the stock. Kimi Ford read all the investors reports after an analysts meeting held by Nike on June 28th 2001. The main points discussed in the meeting were that the company was planning to address two main issue of growth and operating performance. The revenues of the company have remained very stable at around $9 billion but the net income has decreased from $800 million to $580 million in the last 5 years. Nikes market share has also taken a dent and gone down in the last 5 years. The company revealed in the meeting that it is now going to develop more athletic shoe products in the mispriced range that was previously overlooked. Besides all this, Nike also bore losses due to unfavorable movement of the currency. Nikes management also told the investors that it was focusing a lot on expense control. The meeting ended with Nikes management sharing their long term growth targets with the attendees. Nikes management was aiming for 8% to 10% revenue growth and 15% earnings growth. Kimi Ford read different analyst reports and they had different suggestions for Nikes stock. So she decided to develop her own discounted cash flow and come up to a stock price that could help her take the decision. Fords forecast showed that at 11.17% and above, Nike was overpriced. She handed over the task of calculating the cost of capital to her assistant Cohen. I agree with Cohen in using the WACC to calculate the cost of capital of the company. The prime reason for that is the capital structure of he company as it is financed with both debt and euity. WACC will give us the best estimate of the companys cost of capital. Although the weight of debt financing is very little compared to the equity but still it cannot be ignored as a component of financing. I did not use multiple cost of capital agreeing with the point made by Cohen that the major business of Nike is apparel and footwear so there was no need for two cost of capital. Cost of Debt Fords assistant Cohen used WACC to come up with 8.4%. She calculated market value of debt by taking the sum of current liabilities, notes payables and long term debt. This is the exact same formula that I used to calculate debt and it came out to be $435.9 million. Debt: 5.40 + 855.3 + 435.9 = 1296.60 For the cost of debt I used the data given in exhibit 4. I calculated the current yield to maturity of Nikes bond to represent Nikes current cost of debt. As given in the exhibit 4 the PV of the $100 face value bond issued by Nike is 95.60. It is paying a coupon rate of 6.75% compounded semiannually. So the annual rate becomes 7.16%. This is the pretax rate and when calculated after tax it becomes as follows: Cost of Debt: 7.16*(1-0.38) = 4.44% Cost of Equity Next calculation that is required is the Market value of equity. Here Cohen used a completely wrong number in the calculation. She took the book value of equity rather than the market value of the equity. This is a very critical mistake because not only it miscalculates the equity but also carries on in the proceeding calculations, giving a very different answer. The number that was supposed to be used here was the product of shares outstanding and the share price at that time. Cohen used 3494.5 which is the share holdders equity in the 2001 balance sheet. I took the market value i.e Equity: 42.09 * 271.5 = 11427.44 To calculate Cost of Equity I used Capital Asset Pricing Model I used the 20 year yield on US treasuries. It was 5.74% and Cohen used the same number too. For the risk premium I chose the geometric mean as it is a better indicator of the real mean when calculating for a long period of time. So I used geometric mean of 5.90% rather than the arithmetic mean. For the beta of the stock I used the average beta of 0.80. So my CAPM is given below CAPM: 5.74 + 0.80*(5.90) = 10.46 WACC My WACC is different from what Cohen calculated largely due to the difference in the debt value. My WACC is: WACC: 4.44 * (1296.6/1296.6 + 11427.44) + 10.46 * (11427.44/1296.6 + 11427.44) = 9.84%

My WACC is higher than Cohens calculation and hence my stock value comes out to be 52.37 which is significantly higher than Fords estimate of 37.27. So considering my calculation of WACC the stock is undervalued and I suggest a strong BUY. Although Cohens calculation would also result in a $58 stock price but her calculation is not correct. I think the companys beta is the biggest player in the companys cost of capital. The reason that I have come to this conclusion is that equity is almost 90% of the total capital structure. Consequently the cost of equity is the biggest part of the WACC. My sensitivity analysis shows that if the beta changes from 0.8 to 0.9 it will change the cost of capital to 10.3%. The cost of debt is not a very major factor due to the small percentage of debt financing used by Nike. As we have seen in the case that there were two values of WACC calculated by Ford and Cohen. These values were about 12% and 8.4% but the effect of the stock price was more than $20. This shows that the companys cost of capital was very critical in calculating the stock price. A small change in WACC brought a big change in the value of the company and this is same in all the companies that have a huge number of shares outstanding, It is a problem but the companies have to bear with it as there is no way around it. This is why the companies have to keep up with the competition and make sure that they are performing well.